The purpose of the sales factor is to include in the apportionment formula a measure of the taxpayer’s customer base within a state. Consistent with this goal, states generally source sales of tangible personal property using a destination test, which assigns the sale to the state in which the property is delivered to the purchaser. In contrast, most states have historically sourced sales of services using the cost of performance rule, which assigns the sale to the state in which a greater proportion of the income-producing activity is performed, based upon costs of performance. A major weakness of the cost of performance rule is that it does not accurately measure a taxpayer’s customer base when a corporation performs services in one state for a customer located in another state. [See Richard Pomp, “Report of the Hearing Officer, Multistate Tax Compact Article IV (UDITPA) Proposed Amendments,” Oct. 25, 2013, http://bit.ly/2bCn9aE.]
In recent years, many states have replaced the cost of performance rule with market-based sourcing rules for sales of services. In 2000, only a handful of states, including Georgia, Iowa, Maryland, and Minnesota, used market-based sourcing rules for sales of services. At present, roughly 20 states and the District of Columbia use market-based sourcing rules. Many of these states have enacted market-based sourcing rules in just the past few years, including New York, which enacted market-based sourcing rules effective for tax years beginning on or after January 1, 2015.
This article identifies common themes in these new sourcing rules and analyzes the practical application of the general-purpose apportionment rules that apply to taxpayers, with a special focus on the New York reforms. It does not address the specialized apportionment rules that many states provide for certain industries, such as broadcasting, construction, financial institutions, telecommunications, and transportation.
Market-Based Sourcing Rules
Statutory rules.
States that have enacted market-based sourcing rules for sales of services employ several different approaches for determining the market state for the services. One approach is to source sales of services based on the customer’s location. For example, Georgia assigns a sale to in-state sources if the “receipts are derived from customers within this state or if the receipts are otherwise attributable to this state’s market-place” [Ga. Code Ann. section 48-7-31(d)(2)(A)(i)]. Likewise, Maryland assigns a sale to in-state sources if the “receipts are derived from customers within this State” [Md. Code Regs. section 03.04.03.08.C.(3)(c)].
Another approach is to source sales of services based on the delivery location. Examples include Massachusetts and Pennsylvania, both of which assign a sale to in-state sources if the “service is delivered to a location” in the state [Mass. Gen. Laws ch. 63, section 38; 72 Pa. Stat. Ann. section 7401(3)2.(a)(16.1)(C)(I)].
A third approach is to source sales of services based on the receiving location. For example, Illinois and Minnesota both assign a sale to in-state sources if the “services are received” in the state [35 Ill. Comp. Stat. 5/304(a)(3)(C-5)(iv); Minn. Stat. section 290.191(5)(j)]. California assigns a sale to in-state sources if the customer “received the benefit of the services in this state” [Cal. Rev. & Tax. Code section 25136(a)(1)]. Michigan also assigns a sale to in-state sources if the customer “receives … the benefit of the service in this state” [Mich. Comp. Laws section 206.665(2)].
Uncertain application.
Taxpayers can usually determine the destination state for sales of tangible personal property by simply looking at the shipping documents. In contrast, the state in which sales of services are delivered or received is not so obvious, which can create uncertainty regarding their inclusion in the state’s sales factor. Consequently, a major challenge for state tax officials is drafting workable rules for determining where sales of services are delivered to or received by customers.
For example, assume a corporation hires an advertising agency to develop a campaign for a new product. The corporation’s headquarters is located in State J. The advertising services are ordered and received by the manager of the consumer products division, which has its offices in State K. The advertising campaign is aimed at potential customers in State L. Depending upon how the market state for sales of services is defined, the sale could be assigned to the customer location (either State J or State K), the delivery or receiving location (State K), or where the benefit of the service is received (arguably, State L).
States that have issued detailed administrative guidance for determining the market state for sales of services include California (Cal. Code Regs. tit. 18, section 25136-2, Mar. 27, 2012), Massachusetts [830 Mass. Code Regs. 63.38.1(9)(d), Jan. 2, 2015], Michigan (Revenue Administrative Bulletin 2015-20, Oct. 16, 2015), Pennsylvania (Information Notice Corporation Taxes 2014-01, Penn. Dept. of Rev., Dec. 12, 2014), Rhode Island [R.I. Reg. CT 15-04.8.(i)(8)(B), Jan. 12, 2016], and Tennessee (New Administrative Rule 1320-06-01-.42, June 28, 2016).
Practical Application of Market-Based Rules
The practical issues that states must address in providing guidance for determining the market state for sales of services include whether to provide 1) different rules for individuals and business entities, 2) special rules for in-person services, 3) fallback rules that taxpayers can apply if the state of assignment cannot be determined under the general rule, 4) the ability to prorate a sale among two or more states, and 5) throwback or throw-out rules if the taxpayer is not taxable in the state of assignment.
Different rules for individual and business customers.
Numerous states, such as California, Georgia, and Illinois, provide different sourcing rules for individuals as opposed to business entities. For example, if the customer is an individual, a key factor may be whether or not the customer’s billing address is in the state. On the other hand, if the customer is a business entity, a key factor may be whether or not the customer maintains a regular place of business in the state.
For example, for purposes of computing the Georgia sales factor, if the taxpayer’s customer is not engaged in a trade or business, the customer is deemed to be in Georgia if the customer has a billing address in the state. On the other hand, if the customer is engaged in a trade or business, the customer is deemed to be in Georgia if the customer maintains a regular place of business in the state [Ga. Comp. R. & Regs. 560-7-7-.03(5)(c)3].
Likewise, for purposes of computing the California sales factor, if the taxpayer’s customer is an individual, it is presumed that the benefit of the service is received in California if the customer’s billing address is in the state. On the other hand, if the customer is a business entity, it is presumed that the benefit of the service is received in California to the extent the taxpayer’s contract with the customer or other books and records, notwithstanding the customer’s billing address, indicate the benefit of the service is received in California. If certain requirements are met, the taxpayer may overcome these presumptions [Cal. Code Regs. title 18, section 25136-2(c)].
Special rules for in-person services.
Some states, such as Massachusetts, Michigan, and Pennsylvania, provide special rules for services that are physically provided in person by the taxpayer, where the customer or the customer’s real or tangible property upon which the services are performed is in the same location as the taxpayer at the time the services are performed. Examples of in-person services include warranty and repair services, cleaning services, plumbing services, pest control services, and medical or dental services. For example, for purposes of computing the Massachusetts sales factor, sales of in-person services are assigned to Massachusetts if the services are performed with respect to an individual customer who is physically present in the state, or if the services are performed with respect to the customer’s real or tangible personal property located in the state [830 Mass. Code Regs. 63.38.1(9)(d)4.b.ii].
Many states permit taxpayers to prorate the gross receipts from a sale of services among two or more states.
Fallback rules.
Most states, including California, Illinois, Massachusetts, and Pennsylvania, provide one or more fall-back rules that taxpayers apply if the state of assignment cannot be determined under the general rule. Common fallback rules include the customer’s billing address, the location of the office from which the services were ordered, and use of a reasonable approximation.
For example, for purposes of computing the Illinois sales factor, sales of services to a corporation, partnership, or trust are assigned to Illinois if the services are received in the state and the customer has a fixed place of business in the state. Illinois provides two cascading fallback rules for such sales. First, if the state where the services are received is not readily determinable or is a state where the customer does not have a fixed place of business, the sale is assigned to Illinois if the office of the customer from which the services were ordered in the regular course of the customer’s trade or business is located in Illinois. Second, if the ordering location cannot be determined, the sale is assigned to Illinois if the office of the customer to which the services are billed is located in Illinois [35 Ill. Comp. Stat. 5/304(a)(3)(C-5)(iv)].
Proration permitted.
Many states, including California, Georgia, Michigan, and Pennsylvania, permit taxpayers to prorate the gross receipts from a sale of services among two or more states, as opposed to requiring an all-or-nothing approach. For example, if the recipient of a service receives only some of the benefit in Georgia, the sale is assigned to Georgia in proportion to the extent of the benefit in Georgia [Ga. Comp. R. & Regs. 560-7-7-.03(5)(c)6.(ii)].
Throw-out rules.
A handful of states, including Illinois, Massachusetts and Tennessee, have enacted throw-out rules that require the taxpayer to exclude a sale from the sales factor if the taxpayer is not taxable in the state of assignment or if the state of assignment cannot be determined. For example, for purposes of computing the Illinois sales factor, if the taxpayer is not taxable in the state in which the services are received, the sale is excluded [35 Ill. Comp. Stat. 5/304(a)(3)(C-5)(iv)].
Importance of Billing Address
One approach to promoting administrative ease is to base the determination of the market state on a customer’s billing address. As discussed above, California and Georgia have adopted general rules for individual customers that rely on the customer’s billing address. Alabama, Louisiana, and Oklahoma have also adopted general rules that rely on a customer’s billing address.
In addition, a number of states, including Arizona, California, Illinois, Maine, Massachusetts, Minnesota, Pennsylvania, Rhode Island, Tennessee, and Utah, have adopted fallback rules that rely to some extent on a customer’s billing address. For example, Pennsylvania assigns a sale of services to in-state sources if the service is delivered to a location in Pennsylvania. If the state in which the service is delivered cannot be determined for a customer who is an individual and is not a sole proprietor, the sale is assigned to Pennsylvania if the customer’s billing address is in Pennsylvania [72 Pa. Stat. Ann. section 7401(3)2.(a)(16.1)(C)(II)].
New York Reforms
A corporation apportions its business income to New York based on the ratio of its total receipts in New York to its total receipts everywhere. In March 2014, New York Governor Andrew Cuomo signed into law a major corporate tax reform that included new market-based sourcing rules for computing the New York receipts factor. The new sourcing rules apply to tax years beginning on or after January 1, 2015, and include separate rules for receipts derived from sales of tangible personal property, electricity, and real property; rentals and royalties; digital products; financial transactions; selected businesses (railroads, trucking, operation of vessels, aviation services); advertising; transportation of gas through pipes; and other services and other business receipts [N.Y. Tax Law section 210-A].
Under the new rules, receipts from “other services” are assigned to New York if the “location of the customer” is in New York [N.Y. Tax Law section 210-A.10(a)]. Examples include receipts from providing accounting, architectural, educational, employment, engineering, healthcare, legal, management consulting, or personal services. Prior to 2015, such receipts were assigned to New York if the services were performed in New York [N.Y. Comp. Codes R. & Regs. Title 20, section 4-4.3(a)].
The determination of whether the location of the customer is in New York is based on the following hierarchy of methods:
- First, whether the benefit is received in New York;
- Second, the delivery destination;
- Third, the New York apportionment fraction for such receipts in the preceding tax year, as determined using this hierarchy; and
- Last, the New York apportionment fraction in the current tax year for those receipts that can be sourced using methods 1 and 2 [N.Y. Tax Law section 210-A.10(a) and (b)].
A major corporate tax reform included new market-based sourcing rules for computing the New York receipts factor.
The statute does not specify how a taxpayer is to determine where the benefit of a service is received (method 1) or where the delivery destination for a sale of services is located (method 2). The New York Department of Taxation and Finance has released proposed regulations for making these determinations, but these regulations have yet to be finalized.
In applying the hierarchy of sourcing methods, a taxpayer cannot simply pick its preferred method and claim that it was unable to apply the earlier rules. Instead, the statute provides that the taxpayer “must exercise due diligence” under each method before rejecting it and proceeding to the next and must base its determination on “information known to the taxpayer or information that would be known to the taxpayer upon reasonable inquiry” [N.Y. Tax Law section 210-A.10(a)].
In addition to the catchall sourcing rule for receipts from “other services,” numerous specialized sourcing rules apply to selected services, such as receipts from certain broker or dealer activities (e.g., advisory services related to mergers and acquisitions), receipts from certain services provided to an investment company (e.g., rendering of investment advice), and receipts from certain digital products (e.g., game, information, entertainment services).
Finally, it is worth noting that New York’s adoption of market-based sourcing rules for sales of services may result in double taxation of the underlying income because many states continue to source sales of services based on some version of the traditional cost of performance rule. For example, New Jersey still sources sales of services based upon where the services are performed [N.J. Admin. Code section 18:7-8.8(a)2]. Consequently, if a corporation performs services in New Jersey for a customer located in New York, the sale might be assigned to both states.
The sales factor plays a dominant role in computing the state income tax liability of a multistate corporation. It is important to keep in mind, however, that the rules for computing the sales factor vary considerably from state to state. Consequently, CPAs must carefully analyze the tax laws of each state applicable to their clients to determine the proper treatment of each sale.
